The current market environment continues to test the resolve of US investors, many of whom are questioning the bond allocation within their portfolios. In 2013, the most widely cited measuring stick for bond market returns, the Barclays US Aggregate Bond Index, declined roughly 2%, marking the index's first calendar year decline since 1999 and just the third such decline since US interest rates peaked in 1981 (Source). Since the advent of modern portfolio theory and by extension diversified investment portfolios, bonds served as a counterbalance to more variable investment categories such as stocks and commodities. In 2008 for example, a portfolio comprised of 100% US Stocks, represented by the S&P 500, declined 37%, whereas a portfolio comprised of 50% US Stocks (S&P 500) and 50% Long-Term US Treasury Bonds declined just 3% (Source). Therefore, despite historically low yields (interest rates), bonds remain an invaluable component of a properly diversified portfolio.

While we firmly believe that bonds deserve a place in investor portfolios, we must reassess our approach to bond investing. With interest rates near historically low levels, there is far more room for rates to increase than decrease, acknowledging that 0% serves as a lower bound. As the chart below illustrates, if the interest rate on the 30-year US Treasury bond increased by 1% "overnight," the price would decline by roughly 18%, despite producing annual income of just 5% after the increase. Therefore, long-term US government bonds do not provide the margin of safety they once did, prompting us to use different bond instruments than were used in the past. This month, we will discuss different approaches bond investors can employ to reduce interest rate risk. We will also illustrate the "disjointedness" of bond returns and the fact that historically, even during prolonged periods of rising interest rates, US bonds delivered positive total returns.

Source: JPMorgan Guide to the Markets 1Q 2014

Different Types of Bonds

Since the peak of interest rates in 1981, a long-term Treasury bond (20-year+ maturity) was perhaps the best vehicle to own as it provided a high level of current income as well as significant price appreciation, with almost no credit or default risk. Employing this same approach over the next several decades is likely to produce different results. Accordingly, investors must utilize different vehicles and strategies within the bond portion of their portfolios. Specifically, investors should consider using shorter term instruments within conventional bond segments (Treasury, Agency, Municipal), diversifying across issuers, and incorporating floating rate loans.

"Duration" is a quantitative measure employed by bond investors to estimate the impact of interest rate movements on bond prices. Shorter (lower) duration bonds offer protection from a rising rate environment because bond price will not decline as much as longer (higher) duration instruments. Moreover, in a portfolio context, short duration bonds will generally mature more frequently, at which time the proceeds from maturing bonds can be used to purchase newer, higher yielding (interest rate) bond issues. These days, investors can find short duration fund options in most sectors including Treasury, High Yield Corporate, Investment Grade Corporate, and Municipals. Therefore, investors can retain the favorable characteristics of bonds at the portfolio level, while significantly reducing interest rate risk.

The second risk management technique in a rising interest rate environment is to diversify across issuers. While most investors are familiar with instruments issued by the US government (Treasuries), these conventional "safe havens" currently offer some of the least attractive yields in absolute terms. Bonds issued by companies, localities, and (non-US) governments around the world can make valuable contributions to an overall portfolio in this regard. Generally speaking, bonds issued by corporations offer higher yields than Treasuries of comparable maturity because of perceived credit risk or other concerns. Emerging market bonds also offer higher yields than Treasuries, with the added benefit that bonds issued outside the US, denominated in the local currency, provide currency diversification for US based investors during periods of US dollar decline. Lastly, Municipal bond income is generally exempt from federal income tax and in some cases, state income tax, depending on residency.

Perhaps the newest technology widely available to individual (rather than institutional) investors is the floating rate loan. These loans periodically reset their coupon payment, often every 90 days, based on a spread to a predefined reference rate such as the London Interbank Offered Rate (LIBOR). Accordingly, as policymakers adjust the reference rate up or down in accordance with prevailing economic conditions, investor income adjusts as well. Because investor income has the potential to increase with every reset in a rising rate environment, floating rate loans can be effective tools to shorten overall portfolio duration.

Positive Total Returns despite Rising Interest Rates*

During the 1920s, 30s, and 40s, two extremely significant events weighed on US capital markets; the Great Depression and World War II. During these periods, characterized by tremendous fear and uncertainty, the interest rates offered by "safe haven" investments like US Treasuries did not need to be very high to attract investors. October of 1941 marked the secular low in interest rates and what followed was a 40-year period over which interest rates trended higher with only limited interruption, ultimately peaking in August of 1981. Over that 40-year period, despite the interest rate on the bellwether 10-year Treasury increasing from 0.51% to over 16%, an investment in a vehicle that passively tracked this index would have still delivered a positive total return. Given time, the increasing income was able to gradually offset the declining price (more on this later). Today, while the interest rate on the 10-year Treasury never quite reached the lows of 1941, bottoming around 1.50% in 2012, we feel the "Period of Rising Rates" portrayed below may be indicative of what to expect from conventional bond investments going forward.

Disjointedness

During periods of rising interest rates, one of the primary sources of "statement risk," as we like to call it, is when investors open their monthly statements and note that the price of their bond instruments declined, perhaps even showing an "unrealized capital loss." The logical misstep that ensues is to extrapolate this price decline indefinitely into the future, and moreover, use that extrapolation to form an expectation about the future total returns of the instrument.

While we already demonstrated how conventional bonds historically delivered positive, albeit less attractive, total returns during long periods of rising interest rates, it is important to understand why they can deliver these positive returns given time. Generally speaking, there are two components of total return; price and income. In the case of bonds, these components are extremely disjointed in that price adjusts to market conditions instantaneously, whereas income adjusts gradually in the form of (increasing) periodic interest payments, trickling in month after month.

Conclusion

We do not believe that bond investments are susceptible to "bubbles" in the same fashion as stocks and commodities. After all, bonds generally have a predefined maturity date and value, anchoring the price appreciation they can experience. This is different from stocks and commodities, neither of which have a predefined "terminal value," making them more prone to irrational prices or "bubbles" and subsequent (sharp) corrections. We believe interest rates in the US will rise gradually and that we can take steps to protect our bond investments in such an environment.

In this month's update, we put forth numerous reasons why bonds belong in investor portfolios as well as some forward looking approaches to bond investing. All of that said, perhaps the most important point we can make is that investors must set realistic expectations for bond returns going forward. Generally speaking, it will be mathematically impossible for investors in US government bonds to recreate the robust returns experienced since 1981. Returns over the next 30+ years may certainly be lower if not below average, but can still be positive, and can provide valuable protection during periods of stock market decline in addition to reliable income for matching liabilities and meeting cash flow needs.

*Past performance is not is not indicative of future results.

The information contained in this article is for informational purposes only and not meant as a solicitation to purchase a specific product. Please consult a financial advisor to discuss your personal circumstances.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. The ETF Authority is a team comprised of two independent financial professionals, Kevin Prendergast and Nathan Rutz. This article was jointly written by Kevin and Nathan. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock or fund is mentioned in this article. Kevin and Nathan may offer securities through ValMark Securities, Inc. 130 Springside Dr, #300 Akron, Oh 44333 (330-576-1234), Member FINRA/SIPC. The opinions expressed in this article are those of the authors, not ValMark Securities, Inc., and are subject to change at any time without notice. This article is not intended to be a recommendation to invest. The securities discussed in this article may not be suitable for all investors. Please consider your personal risk tolerance and investment objectives carefully before considering any investment and consult your tax, legal, and financial professionals.